Understanding the Home Equity Loan Tax Deduction

Understanding the home equity loan tax deduction is paramount when making the decision as to whether or not to embark upon the process of taking out such a loan.

Loans that you take out and are secured by the value of your home for your main residence, or even a second residence, qualify for the home mortgage interest deduction under IRS rules.

Types of mortgages that qualify are a mortgage taken out to finance the purchase of your home, second mortgages, and lines of credit such as a home equity loan. Interest that is paid for these types of loans are deductible from your Federal tax return.

If you qualify for the interest deduction rules, you would file a regular 1040 tax form (the long form) and record your interest for that tax year on Schedule A of the 1040 form. You can get the amount of the interest from your mortgage company, and most mortgage companies will provide that amount for you as a courtesy at the end of the year.

There are some limitations on the size of the mortgage and what you can deduct, however. If your mortgage was taken out after October 13, 1987 there is a limitation on the amount of interest you can deduct. The amount of the mortgage cannot exceed 1 million in order to be able to deduct the interest on it. The money here that is included is money that was not used to buy, build or improve your home.

Mortgages that were taken out prior to October 13, 1987 are considered to be “grandfathered” and that money does not necessarily have to adhere to these rules.

There is an IRS worksheet located in Part II of IRS Publication 936 which will walk you through the process.

Still, for most people, they will get to use all or a large part of their mortgage interest as a deductible item, and it can have a sizable impact on their ultimate tax burden. Since in the early years of a mortgage most of the mortgage payment is pure interest, it creates a rather large deduction.

As a mortgage is amortized, it gradually works in the principal very slowly, with just a little bit each year being calculated as principal. For example in a new, 30 year mortgage of say $3,000 per month, since most of the payment is interest, the new homeowner will have a write off amount of somewhere just shy of $36,000 the first year of his mortgage on his income taxes.

That puts the homeowner in a much lower tax bracket, and it is most likely the largest tax deduction he will have. Each year the deduction will decrease slightly as the amortization schedule will gradually increase the principal credited to the account and reduce the interest proportionately.

For most homeowners, the home equity loan tax deduction works the same way as the first or second mortgage tax deduction, except the interest is not amortized, but is assessed on the amount of the loan that is outstanding. However, this is only for that specific period of time. If the loan is paid back, there is no interest, so there would be no deduction.